By Taos Turner and Ken Parks

BUENOS AIRES--Argentina could make unfortunate history this week if it defaults on its foreign debt for the second time in 13 years as a showdown with creditors comes to a head.

When Argentina last defaulted on this debt, in 2001, it was the biggest sovereign default ever. It led to a debt restructuring and the country's deepest recession since the Great Depression. The political turmoil was so bad that the country had five presidents in just over a week.

The seeds of the current drama were sown not long after that, when investors bought the country's defaulted bonds but never accepted its terms for restructuring the debt. Now they are standing in the way of payouts that would avoid a default this week.

Although there is little fear of contagion for other emerging markets and minimal concern Argentina would suffer the kind of economic implosion of 13 years ago, a default still could cost one of Latin America's biggest economies dearly, keeping it shut out of international credit markets and crimping credit to companies. It also could complicate the transition to a new government after next year's presidential election.

"To me it is very clear that Argentina is heading to default," said former Argentine finance secretary Guillermo Nielsen in a recent interview. "For most Argentines, this means the economic stagnation will be harsher. There will be less money on the street."

Mired in recession, Argentina already suffers from hard-currency shortages and annual inflation some economists estimate at 40%. A default could pressure the peso by undermining confidence, fuel inflation by making imports more expensive and worsen unemployment. It also could reduce Argentina's foreign-currency reserves, already among the lowest in the region at $29.7 billion.

Last week, the mere expectation of a default pushed Argentina's black-market exchange rate to 12.65 pesos to the U.S. dollar, far from the official rate of 8.17 offered at banks. A month ago, the black-market rate was 11.65. Argentina's underground currency market was born a few years ago when the government limited the sale of dollars.

"All of that would lead to a deeper recession," said Gustavo Cañonero, a senior economist at Deutsche Bank.

So with such downsides, why would Argentina even consider default as an option? The answer is almost as complex as Argentina itself, a country whose tendency toward home-brewed political and economic crises has baffled analysts for decades.

Unable to pay its bills after its historic economic meltdown in 2001-2002, Argentina slashed its debt burden by getting investors to exchange almost 93% of their defaulted bonds for new debt in restructurings worth about 33 cents on the dollar. The remaining stock of foreign-currency-denominated bonds issued during the debt restructurings and which could be affected by the court ruling was almost $29 billion as of Sept. 30, 2013.

But some hedge funds which had snapped up defaulted bonds on the cheap bet they could force Argentina to pay the bonds in full. Led by Elliott Management Corp. and Aurelius Capital Management LP, they rejected the restructuring terms and successfully sued Argentina in the U.S., where the bonds had been issued.

U.S. District Judge Thomas Griesa has ruled that Argentina must pay the funds the full value of the bonds. When the U.S. Supreme Court refused to hear the case in June, the clock began ticking on Mr. Griesa's order that Argentina effectively pay the funds by Wednesday or risk being declared in default.

To force Argentina's hand, Mr. Griesa ruled thatArgentina can't pay other bondholders--who did accept the restructuring terms--unless it simultaneously pays the holdout hedge funds. But doing that, Argentina says, would put the country in a tremendously costly legal bind.

That is because of a clause written into the restructured bonds--the "Rights Upon Future Offers" or RUFO clause--that could give bondholders who accepted the haircut the right to demand the same terms of any deal Argentina might reach with the holdout creditors. That could spark $120 billion in legal claims, Argentina says.

Talk of the clause has become so common on Argentine radio and TV that it seems nearly everyone here seems familiar with it. President Cristina Kirchner even said in she could be held criminally responsible if she triggers the clause.

"What most worries me isn't the criminal responsibility," she said in a speech last week. "What most worries me is my responsibility before history, beforethe eyes of my children, my grandchildren and millions of Argentines who are not going to see me sign off on something under the threat that the world will fall apart."

Legal experts debate the relevance of the clause, which could only be triggered if Argentina "voluntarily" paid the hedge funds. Complying with a court order wouldn't be voluntary behavior, some lawyers say.

Given that the RUFO clause expires on Dec. 31, Argentina has pushed the judge to suspend his order to give Argentina more time. He hasn't budged, however, and the hedge funds claim the clause is a ruse to avoid paying.

Last month, Mr. Griesa appointed a mediator to oversee talks between the parties but Argentina has refused to meet face to face with the hedge funds. On one occasion, Argentine officials even failed to arrive at a meeting with the mediator.

Whatever happens this week, Mrs. Kirchner says Argentina cannot be considered in default becauseit already deposited the $539 million in interest that must be paid on the restructured bonds by Wednesday. Last month, Argentina gave the cash to Bank of New York Mellon Corp., the bond trustee. Mr. Griesa blocked the bank from paying the creditors, and the bank is now being sued by bondholders for not distributing the money.

"I want to tell all Argentines that Argentina will not be in default," Mrs. Kirchner said recently. "Because those who default are those who don't pay--and Argentina paid."

That line of thinking resonates with many Argentines who back Mrs. Kirchner's stance against the investors she calls "vulture funds."

"What we have is an unprecedented situation in which a judge is blocking the right of bondholders to get paid," said Fernanda Vallejos, an economist at La Gran Makro, a pro-government think tank.

Many ordinary Argentines are taking the threat of default in stride.

"I've lived through so manycrises I can't be bothered to worry about this," said Mariano Torga, 70, an electrician who works in a repair shop.

"We do not discount some stress in local markets and a worsening in stagflation; however we do not believe that [a default] would catalyze a broader economic crisis," Jeffries analyst Siobhan Morden said in a recent report.

A recent poll by Poliarquia indicated that 47% of Argentines view the president's way of dealing with the hedge funds positively--up from 38% a month ago.

"Fighting the vultures, their millionaire owners, and U.S. judges caricatured as intransigent conservatives is the dream of any populist leader, especially in a country with a strong state, anticapitalist tendencies and a minimal tradition of respecting rules," Poliarquia analyst Alejandro Catterberg wrote in a local newspaper column last week.

That is hardly comforting to Mr. Nielsen, who was finance secretary under Mrs. Kirchner's late husband and predecessor, Néstor Kirchner.

"I'm worried because there is a sort of naive view of what constitutes default at this point," he said. "Argentina has gone through many problems by miscalculating possible outcomes and I'm very afraid this is another case of that."

(END) Dow Jones Newswires

July 27, 2014 19:32 ET (23:32 GMT)

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